(FORTUNE Magazine) – THWARTED IN EVERY attempt to diversify successfully, Philip Morris, the , world's largest and most stunningly profitable cigarette company, is finally beginning to conquer its addiction to tobacco. It hasn't been easy. Past acquisitions in the food business -- Seven-Up, Miller Brewing, General Foods -- have not added much to profits. But with its $12.9 billion hostile takeover of Kraft last December, Philip Morris seems to have picked a winner. If Philip Morris can meld Kraft with lumbering giant General Foods -- and if the finances work out, as it appears they will -- the move could touch off a cycle of profitable diversification that will last for years. The good news comes none too soon. If ever a company needed more diversity, this is it: The tenth-largest enterprise in the FORTUNE 500, Philip Morris depended on a single brand, Marlboro cigarettes, for nearly 60% of its profits last year. ''We want to be known as a consumer-products company,'' says Hamish Maxwell, Philip Morris's genteel Scottish CEO. Tobacco, however, continues to throw off much more cash than any of the company's acquisitions. Getting Philip Morris off cigarettes has seemed as hopeless as offering an inner-city crack dealer a job flipping burgers at McDonald's. ENVIABLE THOUGH they may seem, these cigarette profits can't last forever. Investors esteem Philip Morris highly but trade its stock at a discount out of concern over tobacco. Cigarette consumption is declining in the U.S., product liability suits remain a risk, and many people reject tobacco stocks on principle. Thanks to Kraft and its vigorous young president, Michael A. Miles, Philip Morris expects its food business, newly named Kraft General Foods, to report operating income of $2.1 billion this year, nearly a third of the corporate total. Great solace to Philip Morris investors, the early success of Kraft General Foods also provides lessons on making a merger work and creating a fast-growing business in a slow-growing industry. The high expectations for Kraft General Foods -- the world's second-largest food producer, after Nestle -- depend less on its unmatched portfolio of cozily familiar brand names (see chart) than on the rigorous cost cutting and back-to-basics management techniques that have become hallmarks of late- Eighties business. In particular they depend on the tough-minded, sleekly groomed Miles, 50, who succeeded John Richman, 61, as chief of KGF last month. A believer in careful analysis and fast action, he is a business junkie who shows up at the office by 6 A.M. and says he does little else but sleep. Pragmatic, ruthless, focused, and lucky, Miles is the very model of the new breed of manager that has climbed out of the rubble of mergers and restructurings across corporate America. If he lives up to his promise, says Maxwell, 63, Miles could climb to the top of Philip Morris itself. The ascent won't be easy. The tobacco company also has talented managers on the cigarette side, including R. William Murray, 53, a Philip Morris vice chairman. But by all reports, the coldblooded Miles fits right in at Philip Morris, whose corporate culture a new employee sums up as ''Screw it; get it done.'' Officers of General Foods -- which Philip Morris acquired in a $5.7 billion hostile deal in 1985 -- deeply resented the takeover and cooperated with their new masters only reluctantly. Some objected to the tobacco business on moral grounds. Only two of KGF's top 15 officers hail from General Foods. Miles and Richman hopped right on board the train. Asked how he feels about the cigarette business, Miles, a nonsmoker, compares the health risks of tobacco with those of cholesterol. He says it's up to the consumer whether to eat eggs or to smoke, regardless of how those products are marketed. He adds, ''I see nothing morally wrong with the business.'' Miles usually communicates in crisp, sober tones. Says he: ''I believe in making sure you've done the obvious things right before you do the less obvious things that are more risky.'' After earning his B.A. in advertising at Northwestern University, Miles joined the Chicago ad agency Leo Burnett. There he worked on such Procter & Gamble accounts as Secret deodorant. Ten years later Heublein, another client, hired him as corporate vice president of marketing. Miles made his name by saving Heublein's Kentucky Fried Chicken restaurant business. Without warning, the chain's company-owned stores suddenly reported big losses in 1977, causing a shocking 64% plunge in Heublein's quarterly earnings and a drop in its stock price. Miles was sent in to put out the fire. At Kentucky Fried he proved his marketing mettle by selling demoralized employees on a comeback program he dubbed QSCVFOOFAMP (pronounced qui-SIV-o- famp), which stands for ''quality, service, cleanliness, values, facilities, other operating factors, advertising, merchandising, and promotion.'' That was a tongue-twisting way of saying they had to fix just about everything, from the stores' menu to training for cooks. But Miles also showed employees how to do it: He introduced fresh buttermilk biscuits and started a Chicken School patterned after McDonald's Hamburger U. Lorraine Scarpa, a Dun & Bradstreet marketing vice president who worked with Miles at Kentucky Fried, remembers him as a demanding but inspirational boss: ''He convinced people that they had a manageable problem, that there were definable things specific individuals could do.'' Miles left Heublein a hero, joining Kraft as president in 1982. AT KRAFT GENERAL FOODS, Miles's mandate is to jolt a $23.9-billion-a-year moo-cow of an organization into rapid forward motion. The process KGF is about to undergo will be similar to what many sleepy old companies experience after a leveraged buyout: a fiery demand for improved productivity and an intensive search for ways to milk more from existing assets. The comforting difference from an LBO will be that Philip Morris, which borrowed $10 billion to buy Kraft, is so rich it doesn't need to sell off big hunks of the company to meet interest payments. Already Miles has met demanding goals. Maxwell -- who resembles actor Charles Laughton and speaks in a quiet voice that gathers your full attention -- pressed Miles to deliver extraordinary gains this year, while Wall Street is watching closely. Miles saluted. Although the food industry is notoriously slow-growing -- the average annual rise in unit sales is under 1%, same as the population -- Miles expects KGF to come in with a phenomenal 27% increase in 1989 operating earnings. That compares with a five-year average of 12% for Kraft and just 5% for General Foods. The great bulk of this year's $400 million profit increase comes from executive purges and other one-time gains. A major source of inspiration was the leveraged-recapitalization plan that Kraft pitched to investors during its brief skirmish with Philip Morris. Kraft had proposed giving shareholders an enormous cash dividend. To finance it, the company would have buried itself in junk bond debt, forcing drastic economies. Soon after winning Kraft, Maxwell got his hands on the proposal. He suggested to Miles that it might be extremely useful in formulating KGF's 1989 business plan, and Miles, no dummy, took the hint. Cost cutting will continue to be a major source of KGF's earnings growth. Most of the productivity savings so far have come from such obvious opportunities as joint purchasing: no-brainers, in business school parlance. The long list of small projects that Miles and his team are amassing accounts for the rest. At Kraft, Miles found he could save big money by carefully tracking lots of efforts to shave as little as $500,000; several hundred such projects are under way at KGF. Improving the accuracy of machines that weigh product portions, for instance, should save $3.5 million in 1989. ''It adds up,'' says Miles. He hasn't had time to sort out the complexities shrouding some of the bigger potential savings. For example, KGF currently operates 34 distribution systems in the U.S. alone. Kraft and General Foods each had a system for frozen foods, another for refrigerated foods, a third for the products that can sit on open shelves, plus specialized systems for such products as Entenmann's baked goods and many more to serve restaurants and other commercial customers. Clearly money can be saved here, but what's the best way to do it? Or consider the 14,500 salespeople the combined company employs worldwide: Would it be more profitable to cut costs by firing a few thousand or to keep them and provide better service to customers? Miles hasn't decided. He says he sees so many more ways to boost productivity or exploit synergies between Kraft and General Foods that he's optimistic KGF can sustain profit growth of roughly 15% a year. That would be enough to lift the company from the drowsy middle of the food-industry pack to the top ranks. Nomi Ghez, a Goldman Sachs security analyst who specializes in foods, believes Miles probably could make his goals for the next three years from cost cutting alone. But that would not satisfy Maxwell, who is justly proud of Philip Morris's ability to sell ever more cigarettes in stagnant or declining markets. ''We're committed to volume growth,'' he says. ''I'm as keen as anyone else on improving returns, but I am even more concerned that the company continues to grow. That's what gets the managerial juices going.'' MILES'S LEADERSHIP style has much the same effect. Asked what he has done to inspire the executives at KGF, Miles smirks just a little and says: ''The trick is to call the management group together and say, 'Last year we were in the middle of the pack. We aren't a middle-of-the-pack company, are we?' Everyone says 'No!' -- at least the smart ones do.'' The smart people who work for Miles have their work cut out for them, since many of Kraft General Foods' venerable brands are losing pep. In an era when consumers are seeking light, healthy, natural products, the line is heavily weighted with fatty, cholesterol-rich, highly processed foods with plenty of artificial ingredients. ''It's a dated portfolio,'' says the head of an ad agency that works for KGF. Indeed, a journalist who recently sampled a variety of the products -- Jell-O ready-to-eat tapioca pudding, lower-salt Oscar Mayer bacon, microwave jalapeno Cheez Whiz -- felt sluggish and troubled for days. The company is responding with trendy line extensions: reduced-fat pastries from Entenmann's, cholesterol-free Miracle Whip, and microwaveable everything. Richard Mayer, 49, a Kentucky Fried Chicken veteran who recently rejoined Miles as head of the General Foods domestic division, calls these efforts ''close-in'' line extensions. For the next few years, he says, they will be the focus of KGF's new-product introductions. That is part of Miles's back-to- basics strategy -- and a sharp contrast to the old General Foods, which introduced more new products last year than any other U.S. company. Though perhaps admirable, General Foods' attempts to develop genuinely new products ate up $100 million a year and added almost nothing to profits. Says Miles: ''The odds against getting a successful major product out of test market are 100 to 1.'' ANOTHER PROMISING area is correcting past mistakes. ''I drool every time I see we're screwing up,'' says Robert Morrison, 47, the Kraft alumnus who heads KGF's Canadian division. ''It spells opportunity in capital letters.'' If so, Morrison had better keep his handkerchief handy. General Foods' Maxwell House coffee unit, the mainstay that produces almost a third of its sales, swung unexpectedly from profits of nearly $150 million in 1985 to a $50 million loss last year. By itself, that swing accounts for most of the difference between General Foods' slow rate of earnings growth and Kraft's more rapid one. ''General Foods lost interest in the coffee business,'' says Maxwell. For nine months the company stopped advertising the brand, a tactic that admen rightly regarded as insane: During those months Maxwell House lost several points of market share. Shocked by the downturn, CEO Maxwell was quick to express his interest in the coffee business. Since then the brand has begun tottering toward a comeback. General Foods improved its blend of coffee beans, introduced successful line extensions -- like Rich French Roast -- and has been advertising heavily. To avoid such calamities, Miles is subjecting each KGF product to systematic review. It will take a while. Kraft General Foods makes so many products that no one there seems to know the total number -- it's somewhere around 2,500 -- and Miles won't delegate as much of the reviewing as one might expect. He is an information-hungry manager who says he likes to get his ''2 cents in'' before subordinates make important decisions. The guy is intense: ''I want to be there,'' he says. Reliable cash producers such as Jell-O will have a home at KGF even if they can't be forced into growth, but Miles plans to ax operations -- even profitable ones -- that he regards as a waste of management time. For example, KGF is trying to sell the Ronzoni pasta business, successful in the Northeast but unlikely to break out as a profitable nationwide brand. Miles is searching for definable points of difference between his products and the competition's that KGF can promote. Where promotable differences don't exist, he hopes to create them, out of thin air if necessary. ''I don't feel bad about selling people products they don't need,'' he says. A success story he points to proudly is Kraft-brand peanut butter, which Kraft has long marketed in Canada with an ad campaign using bears. The company found that when it put the product in a jar shaped like a bear's head, consumers were willing to pay a premium for it. Similarly, the company hyped sales of Cheez Whiz, a bright orange spread that resembles cheese, simply by pitching it as a microwaveable sauce. Miles likes the sort of highly focused advertising that rarely wins awards. ''His idea of good copy is, 'Dirt can't hide from intensified Tide,' '' says an ad executive who works for KGF. Advertising is one of the two major areas in which KGF and Philip Morris can achieve significant synergy. With an ad budget of more than $2 billion a year, Philip Morris is the world's largest advertiser. Finance is the other area where KGF and its parent really mesh. To fully appreciate the fit, one must reconsider the familiar facts about the tobacco business. They remain astonishing, particularly in the context of today's public outrage over drugs. According to the National Institute on Drug Abuse, cigarettes are as addictive as heroin or crack. One-sixth of all deaths in the U.S. are from cigarette-related ailments; that adds up to hundreds of thousands more deaths each year from cigarettes than from crack, even when drug-associated violence is taken into account. Public health warnings have led an estimated 40 million Americans to kick the habit or avoid it altogether, creating a population of smokers dominated by hard-core addicts and young people, to whom death is not an immediate concern. These customers are exceptionally loyal. In the U.S., by far the most profitable market, they have accepted price increases that have outpaced inflation by four percentage points annually in the last decade alone, allowing industry sales to grow and margins to fatten despite 2% annual declines in cigarette consumption. Brilliant at marketing, Philip Morris has enriched itself by capturing far more than its share of the business. A few decades ago it ranked sixth out of six U.S. competitors. Today it is No. 1, with 40% of the market. The company has reinvested as much cash as it can in tobacco: about $3.2 billion, which has bought the most efficient cigarette plants anywhere. But in recent years Philip Morris has had plenty of cash left over, and between now and 1994 it expects to produce $12 billion of excess cash. Philip Morris would be the perfect financial machine but for one problem: Its main product is killing its customers. THIS IS WHERE the food business comes in. Buying businesses the size of Kraft and General Foods costs a lot of money, and a lot of money is precisely what Philip Morris has. Food companies haven't historically required much capital to operate, and usually produce fair sums of excess cash themselves. That helps pay down the debt Philip Morris incurs to buy them. By heavily leveraging its acquisitions, Philip Morris buys a lot of earnings for relatively little cash: It invested only $1.2 billion of cash in Kraft, which will produce earnings before interest and taxes of more than $1 billion this year. That sum roughly equals the annual interest Philip Morris must pay on the money it borrowed to buy Kraft. The tobacco company plans to use most of its ample excess cash to rapidly pay down that debt, further boosting earnings by reducing interest charges. Substantial cuts in interest costs easily could transform a 12% increase in KGF's operating income into a 20% increase in net income. The result: Philip Morris buys the non-tobacco earnings investors prefer without damaging its own financial results even in the short term. Over time, such wizardry might induce Wall Street to trade Philip Morris shares at a higher multiple of earnings, rewarding investors. ! The beauty of this game is that Philip Morris can play it again and again, because the food industry is enormous. For all its size, KGF has only 9% of the U.S. grocery market and less overseas. By late 1991 security analysts expect Philip Morris to have paid down enough debt to take on another major acquisition. Maxwell says he regards the food business, particularly abroad, as rich with opportunities. Successful though it appears at this early date, Philip Morris's push into foods could yet fail. Even assuming the company's food earnings continue to grow, the diversification wouldn't be entirely successful if they didn't expand as fast as those astonishing tobacco profits. A high-ranking former executive of General Foods, who stayed on after the Philip Morris takeover, believes tobacco people chronically underestimate the complexities that food industry managers face, like those 34 channels of distribution. Richman of Kraft voices a similar concern. Says he: ''I worry about the complexity. I mean, this is a big mother!'' To that, Maxwell quietly offers a reply: ''I'm less concerned about complexity,'' he says. ''Jeez, if you can run the United States or New York City, you ought to be able to run a food company. It's just a management challenge.'' As for Miles -- he's happily up to his eyeballs in work.

CHART: NOT AVAILABLE CREDIT: SOURCE: BROWN BROTHERS HARRIMAN & CO. CAPTION: AN UNMATCHED PORTFOLIO OF FAMILIAR BRANDS

CHART: NOT AVAILABLE CREDIT: NO CREDIT CAPTION: INVESTOR'S SNAPSHOT PHILIP MORRIS